The United States Bankruptcy Court for the Southern District of New York recently held that it had personal jurisdiction over a foreign defendant that was paid funds pursuant to the Court’s order approving the debtors’ post-petition financing (the “DIP order”), denying defendant Immigon’s[1] motion to dismiss an adversary proceeding commenced by the Motors Liquidation Company Avoidance Action Trust seeking to clawback the funds.[2]

In 2006, General Motors entered into a $1.5 billion Term Loan Agreement under which JP Morgan Chase Bank, N.A. and several other large financial institutions committed to provide funding and had the right to sell interests in the loan in the secondary market. In 2008, in connection with terminating a completely separate transaction, JP Morgan mistakenly authorized the termination of the security interest in the General Motors’ assets securing the loan.

Under the debtors’ DIP order, the Court authorized the debtors’ to pay in full all of General Motors’ obligations under the Term Loan Agreement, subject to the Official Committee of Unsecured Creditors’ right to investigate and challenge the perfection of the liens securing the loan. Following entry of the order, GM paid approximately $1.4 billion to its lenders under the Term Loan Agreement, including approximately $9.8 million to defendant Immigon on account of its $10 million interest in the loan purchased on the secondary market from JP Morgan.

In denying Immigon’s motion to dismiss, including on the grounds that the Court lacked personal jurisdiction over Immigon, the Court found that under the Term Loan Agreement, Immigon had expressly consented to personal jurisdiction in New York and waived the right to object to any New York State or Federal Court as the forum for any disputes arising out of the Agreement. Moreover, the Court found that the consent to jurisdiction and forum selections clauses should be enforced because Immigon “enjoyed the benefits and protection of New York law” in connection with the Agreement.

As a separate basis for exercising jurisdiction, the Court also held that Immigon consented to jurisdiction under the DIP order, which provided that any party receiving funds under the order consented to the jurisdiction of the Bankruptcy Court. Relying on evidence showing that an employee of Immigon had actually received and viewed the DIP order before receiving payment, the Court found that Immigon had knowingly consented to the jurisdiction provision in the DIP order by accepting payment of the funds.

As a third distinct basis for exercising jurisdiction over Immigon, the Court held that even if Immigon had not consented to the Court’s jurisdiction, sufficient minimum contacts existed between the litigation, New York and Immigon for the Court to exercise specific personal jurisdiction over Immigon. Specifically, the Court noted that “the lending relationship under the Term Loan Agreement was centered in New York, governed by New York law, and allowed all of the parties, including [Immigon], to enjoy the benefits of the U.S. banking system and New York’s status as a financial capital.” Immigon selected Bank of New York Mellon for its correspondent bank account and JP Morgan made the disputed payment to Immigon’s New York bank account. The Court found these contacts, among others, sufficient to show that Immigon had purposefully availed itself of the privilege of doing business in New York.

Finally, the Court found that subjecting Immigon to personal jurisdiction on any of these three grounds would not offend due process because the Court has a strong interest in adjudicating claims that arise under the Bankruptcy Code and the Trust has a strong interest in obtaining convenient and effective relief in the Bankruptcy Court. Moreover, the Court found that Immigon’s burden in having to litigate in New York is mitigated by the convenience of modern communication and transportation.

Practical Implications

The outcome of this case suggests the need for parties to carefully review proposed Bankruptcy Court orders affecting their rights. Here, in finding that Immigon had knowingly consented to the Bankruptcy Court’s jurisdiction in the DIP order, the Bankruptcy Court relied on evidence showing that an employee of Immigon had received and viewed the DIP order, despite the fact that the consent to jurisdiction provision was on page 26 of the 30-page order. The case also suggests the need for caution by parties purchasing interests in transactions governed by agreements with consent to jurisdiction clauses.

[1]. Immigon, or Immigon Portfolioabbau AG, is a wind-down company operating under Austrian law, and is the successor in interest to OEVAG, or Osterreichische Volksbanken Aktiengesellschaft, which was the central institute of the Austrian co-operative of banks named Volksbanken.

After a 2014 decision in the Southern District of New York holding that section 316(b) of the Trust Indenture Act (“TIA”) barred any non-consensual restructuring that impaired a creditor’s actual ability to receive payment, issuers, creditors and the financial markets more generally have been uncertain as to the contours of permissible out-of-court restructurings.[1] The recent decision by the Second Circuit Court of Appeals in Marblegate Asset Management, LLC v. Education Management Finance Corp., 2017 WL 164318 (2d. Cir 2017) reversed the 2014 ruling and held that section 316(b) only bars restructurings that that impact a creditor’s core payment right, which is different from the practical ability to demand payment. The Second Circuit’s Marblegate ruling will help resolve the disquiet among practitioners and issuers and restore expectations as to the ability of companies to conduct out-of-court restructurings without being hamstrung by non-consenting creditors.

Background of the Marblegate Rulings:

The Second Circuit’s decision arose from the restructuring of the debt of Education Management Corporation (“EDMC”). EDMC is a for-profit higher education company that had: (i) $1.3 billion in secured obligations that were collateralized by virtually all of EDMC’s assets, and (ii) $217 million of unsecured notes (the “Notes”) that were issued by a subsidiary of EDMC and governed by an indenture qualified under the TIA (the “Indenture”). The Notes were guaranteed by EDMC, but the guarantee was basically worthless as it had been issued solely to satisfy EDMC’s reporting obligations and would be automatically released if any secured creditor provided a release of any separate guarantee of EDMC (a fact that was clearly disclosed to potential Noteholders in the offering circular for the Notes).

Cash-strapped EDMC entered into negotiations with its secured creditors that resulted in a restructuring proposal.[2] Under the proposed restructuring, the secured lenders would exercise their rights under their credit agreement and Article 9 of the Uniform Commercial Code to foreclose on all of EDMC’s assets and release EDMC from their guarantee (thereby automatically releasing EDMC from the Note guarantee). The secured lenders’ collateral agent would then transfer all of the foreclosed assets to a newly created subsidiary of EDMC that would then issue new secured debt and stock to the secured lenders and any unsecured lenders that consented to the restructuring. Importantly, the restructuring did not change the actual payment terms of the Indenture or limit the Noteholders’ ability to sue the EDMC subsidiaries that issued the Notes to collect the payment due on the Notes (albeit a futile exercise, because the EMDC subsidiaries would have no assets after the restructuring).

All of EMDC’s creditors, representing 98 percent of the company’s debt, consented to the proposed restructuring. The sole holdout creditor was Marblegate Special Opportunity Master Fund (“Marblegate”), which sued to enjoin the restructuring on the grounds that it violated the TIA.

The District Court Decision

Noting that the TIA itself was ambiguous, the District Court agreed with Marblegate and held that the proposed restructuring violated Section 316(b) of the TIA,[3] which prohibits any restructuring that “impair[s] or affect[s]” the “right” of any security holder to receive payment due under a note.[4] After reviewing the text and legislative history of Section 316(b), the District Court concluded that the TIA “protects the ability” of the Note holders “to receive payment in some circumstances.”[5] Even though the Indenture payment terms remained the same, the District Court held, Section 316(b) is violated whenever a transaction “effect[s] an involuntary debt restructuring.”

EDMC appealed and argued that the prohibition contained in section 316(b) of the TIA applies only to non-consensual amendments to an Indenture’s core payment terms (here the ability of Marblegate to commence suit to demand payment from the EDMC issuers).

The Second Circuit’s Ruling

The issue before the Second Circuit therefore was whether section 316(b)’s prohibition on any restructuring that “impair[s]” or “affect[s]” a “right . . . to receive payment” contained in Section 316(b) of the TIA should be read narrowly to bar only non-consensual amendments to an indenture’s core payment terms, or whether it should be read broadly to prohibit any restructuring that affects the ability of a noteholder to receive payment. After a review of the parties’ competing readings of the statute, the Second Circuit agreed that the text of Section 316(b) was ambiguous on this issue.[6] The court noted that the use of “‘right’ to describe what it sought to protect from non-consensual amendment suggests a concern with the legally enforceable obligation to pay that is contained in the Indenture, not with a creditor’s practical ability to collect on payments.”[7] However, the Court also noted that the section of 316(b) stated that such a right “cannot be ‘impaired or affected,’” and Congress’ inclusion of these terms implied that a creditor’s payment right could not validly be reduced or “otherwise affect[ed] in an injurious manner.”[8]

To resolve these competing interpretations, the Second Circuit analyzed the legislative history of the TIA and ultimately concluded that Congress intended a limited application of the prohibition contained in Section 316(b).[9] Based on its review, the court determined that Congress was well aware of “possible forms of reorganization available to issuers, up to and including foreclosures like the one that occurred in this case” and noted that “foreclosure-based reorganizations were widely used at the time the TIA was drafted.”[10] This fact, combined with the expert testimony submitted to Congress at the time of the TIA’s drafting on the limited purposes of the TIA, demonstrated that Congress intended section 316(b) of the TIA to be applied narrowly to bar revisions to the core payment terms of an indenture but did not intend to prohibit the type of foreclosure-based restructuring employed by EDMC.

In addition, the court noted that the broad reading of section 316(b) put forth by Marblegate and endorsed by the District Court raised a number of practical problems, as it would require courts in every case to divine “whether a challenged transaction constitutes an ‘out-of-court debt restructuring . . . designed to eliminate a non-consenting holder’s ability to receive payment.’”[11] The practical requirement of determining the subjective intent of the parties to the restructuring, as opposed to a review of the transaction itself, ran afoul of the Second Circuit’s “particular distaste for interpreting boilerplate indenture provisions based on the ‘relationship of particular borrowers and lenders’ or the ‘particularized intentions of the parties to an indenture,’ both of which undermine ‘uniformity in interpretation.’”[12]

Conclusion

The Second Circuit’s ruling provides a framework by which companies can achieve out-of-court restructurings even though they might deprive dissenting creditors of the value of their notes. The fact that core payment terms remain unchanged, though, may encourage companies to take a more aggressive stance with creditors. Nevertheless, creditors are not without remedies, as the preservation of core payment terms allows dissenting creditors to pursue judicial remedies. The ability of dissenting creditors to pursue successor liability or fraudulent conveyance claims may operate as a check against restructurings that are not conducted at arms’ length or with improper intentions to deprive certain credit groups of payment.

[4] Section 316(b) of the TIA, entitled “Prohibition of impairment of holder’s right to payment,” provides:

Notwithstanding any other provision of the indenture to be qualified, the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security, on or after the respective due dates expressed in such indenture security, or to institute suit for the enforcement of any such payment on or after such respective dates, shall not be impaired or affected without the consent of such holder, except as to a postponement of an interest payment consented to as provided in paragraph (2) of subsection (a) of this section, and except that such indenture may contain provisions limiting or denying the right of any such holder to institute any such suit, if and to the extent that the institution or prosecution thereof or the entry of judgment therein would, under applicable law, result in the surrender, impairment, waiver, or loss of the lien of such indenture upon any property subject to such lien.

[6] Judge Straub dissented on this basis and believed that the text of the TIA was clear and unambiguous and supported the District Court’s ruling. Judge Straub noted that if Congress had “intended merely to protect against modification of an indenture’s payment terms, it could have so stated” and that “nothing in the text of the statute requires the narrow reading that Section 316(b) merely prohibits modification of an indenture’s core payment terms (amount and due date) by noteholder majority action without consent of the individual noteholder.” He recognized the practical difficulties and uncertainty that his interpretation of the TIA would cause, but noted that such concerns were insufficient to override what he reasoned was the correct reading of the statute.

[9] Starting in 1936, the Securities and Exchange Commission (SEC) published a comprehensive eight-part report examining the role of protective committees in reorganizations.5 Part VI of that report, published in 1936 and entitled “Trustees Under Indentures” (the “1936 SEC Report”), led to enactment of the TIA. Additionally, the Court reviewed subsequent congressional reports, testimony, and other statements by SEC officials in reaching its decision.

This article can be found in the New York Law Journal‘s Corporate Restructuring and Bankruptcy special report.

Amidst the sometimes dramatic fluctuations in commodity prices that buffet the oil and gas industry, investors generally relied on one segment of the market to be safe and stable: so-called “midstream” companies that own the pipelines that transport oil and gas. The rationale was that the oil and gas had to travel, and the fare had to be paid, regardless of the commodity price – not to mention that “take or pay” contracts were the norm in the industry. Investors’ perception of the safety of investments in midstream companies – i.e. the owners of the pipelines – was shaken by a March 2016 decision out of the Southern District of New York Bankruptcy Court permitting a bankrupt oil exploration company to reject its midstream service contracts. In re Sabine Oil & Gas Corp., (No. 15-11835 SCC) (Bankr. S.D.N.Y. March 8, 2016, ECF No. 872) (“Sabine”). Sabine set the stage for several heated battles over a debtor’s ability to reject midstream contracts, and, in the process, introduced concern regarding midstream companies’ cash flows. These conflicts arise at the intersection of the core bankruptcy tool of contract rejection, centuries-old state property law, and how the financing that supported the recent expansion of domestic oil and gas production was structured.

This article discusses the details of these conflicts and how the parties have achieved either resolution or the ability to move on despite the continuing lack of definitive answers in every case.

In order to be retained to provide bankruptcy services to a debtor, most professionals generally need to satisfy the “disinterestedness” requirement of Bankruptcy Code Section 327(a). Typically, in order to be “disinterested,” among other things, the professional in most cases cannot be a creditor of the debtor, have outstanding invoices, at the time of the chapter 11 filing. However, despite this general requirement, a recent memorandum opinion in the U.S. Bankruptcy Court for the Eastern District of North Carolina (Greenville Division) leaves open the door for the possible post-petition payment of pre-petition amounts due to a professional.

In Gunboat International, Ltd., the Bankruptcy Court previously held that counsel may provide post-petition services, be retained under Bankruptcy Code section 327(a) and be considered “disinterested,” while still retaining an approximately $12,000 pre-petition claim. The Court directed that the pre-petition fees and expenses due be included in the professional’s fee application at which time there would be an opportunity to object to any amounts that did not specifically relate to the chapter 11 filing.[1]

Subsequently, the U.S. Bankruptcy Administrator, the North Carolina equivalent of the Office of the United States Trustee, objected to the counsel’s request as to these pre-petition fees and expenses because many of the time entries supporting the request did not relate to specifically preparing the chapter 11 petition or related first-day motions. The Bankruptcy Court disagreed, finding that preparing a chapter 11 case does not merely relate to “physically preparing initial forms and motions.” It applied a “logical and temporal nexus interpretation” as to whether pre-petition claims may be retained and paid while still preserving “disinterestedness.” It found that all amounts requested in the pre-petition invoice fell within this nexus.[2] The Bankruptcy Court then determined that the pre-petition fees and expenses were entitled to administrative priority under the Bankruptcy Code. However, the Bankruptcy Court sternly warned that it was not “condoning bankruptcy attorneys routinely filing petitions prior to being paid for pre-petition services” and that was not the “preferred practice.”[3]

While this Bankruptcy Court’s decision may provide a lifeline to professionals who are left with unpaid invoices prior to a bankruptcy filing, Gunboat has yet to be applied in the busy restructuring courts in Delaware and New York.

Yesterday, the Supreme Court granted certiorari in Czyzewski v. Jevic Holding Corp (“Jevic”). As previously reported, Jevic addressed whether a bankruptcy court can approve a settlement agreement that provides for distributions that violate the absolute priority rules as part of the structured dismissal of a chapter 11 proceeding. The Third Circuit held that such structured dismissals were appropriate even when they provided for distributions that do not strictly comply with the Bankruptcy Code’s absolute priority schemes. The Third Circuit’s ruling is consistent with the Second Circuit’s holding in In re Iridium Operating LLC,[1]which held that such structured dismissals may be appropriate if they are justified by other factors, but put the Third Circuit in conflict with the Fifth Circuit, which held in Matter of AWECO, Inc.[2]that it was inappropriate to approve a structured dismissal that did not strictly comply with the absolute priority rule. The Supreme Court will now address this circuit split and decide whether the flexibility offered to debtors (and some creditors) by structured dismissals outweighs that impact that such dismissals can have on the rights of other creditors and interested parties as discussed in our prior post. The Supreme Court’s decision may also have a broader impact on non-priority distributions more generally and could affect the permissibility of “gift plans,” which are similar to the structured dismissals in Jevic as they often provide for secured or senior creditors to make payments to junior creditors in order to garner support for chapter 11 plans. Check back with the HHR Bankruptcy Report as we continue to cover the briefing, developments, and potential impact of Jevic.

Last summer, the HHR Bankruptcy Report analyzed the Third Circuit’s ruling in Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.),[1]which approved, as part of the structured dismissal of a chapter 11 proceeding, a settlement agreement that allowed distributions that violated the absolute priority rule. Following the Third Circuit’s ruling, the aggrieved priority creditors filed a writ of certiorari in the hope that the Supreme Court would address the split between the Courts of Appeals as to whether settlements must follow the absolute priority rule.[2] Now, in response to an invitation from the Supreme Court, the Solicitor General has submitted an amicus brief on behalf of the United States encouraging the Court to grant certiorari and to overturn the Third Circuit’s ruling.

The United State government has a particular and somewhat unique interest in having the Supreme Court review the Third Circuit’s decision. Federal taxing authorities (e.g. the IRS) are granted either second priority or eighth priority claims by the Bankruptcy Code depending on whether the tax obligation arose pre or post-petition. Accordingly, the government recognizes a real danger that, as a result of the Third Circuit’s ruling, debtors could collude with junior creditors to “squeeze out” government tax claims with a higher priority.

At issue in Jevic was the approval of a settlement agreement between the debtor, the Unsecured Creditors’ Committee and defendants to fraudulent transfer actions, that provided, in part, for (i) distributions to certain administrative and unsecured creditors as part of a structured dismissal of the chapter 11 proceeding, but did not provide for (ii) distributions to the debtor’s former employees who held higher priority claims arising from WARN Act liability. The former employees objected to the approval of the settlement on the ground that a bankruptcy court cannot approve a settlement and related structured dismissal of the case that does not comply with the order of priorities set out in section 507 of the Bankruptcy Code. Relying on the fact that it was highly unlikely that the debtor would confirm a plan of reorganization or that the employees would receive any distribution in a chapter 7 liquidation, the Third Circuit rejected the employees’ argument and held that a chapter 11 proceeding may be resolved, in rare circumstances such as those presented in the Jevic proceeding, through a structured dismissal that deviates from the Bankruptcy Code’s priority scheme.

The Solicitor General argued in his amicus brief that the Third Circuit had erred in reaching its holding for a number of reasons. First, the order of priorities established by the bankruptcy code reflects Congress’s detailed balancing of the rights and expectations of various creditor groups, and that by approving a settlement that deviated from this order of priorities, the bankruptcy court was upending “that carefully balanced system.” The Solicitor General noted that this outcome was particularly incongruous when compared to the requirements for chapter 11 plan confirmations and chapter 7 liquidations where priority creditors must be paid first (unless they consent to impairment). Second, the Solicitor General disagreed with the Third Circuit’s reasoning that a deviation from the Bankruptcy Code’s priority scheme was justified by the fact that the employees would not be prejudiced by the settlement because there was no prospect of a chapter 11 plan being confirmed or of a distribution to priority creditors if the case was converted to a chapter 7 liquidation (i.e. the employee creditors would be in the same position whether or not the settlement was approved). The Solicitor General noted that if the case had “simply been dismissed” pursuant to section 1112 of the Code, the employees could have pursued a fraudulent –conveyance action against the settling defendants on a derivative basis as creditors of Jevic. So rather than being outcome neutral, the employee creditors were being directly deprived of a potential source of recovery. The Solicitor General also argued that granting certiorari was appropriate in this case because of the existing split between the Circuitx on this issue, as well as the real and significant impact the ruling could have on the rights of creditors in future proceedings.

The Solicitor General’s amicus brief highlights the potentially wide impact of the Third Circuit’s ruling, despite the court’s attempt to limit its holding to cases where “specific and equitable grounds” justify deviation from the priority scheme. It is conceivable that in nearly every case where a debtor is administratively insolvent, a justification could be found for deviating from the absolute priority rule under the Third Circuit’s ruling. In those circumstances, debtors will be able to apply strong bargaining pressure on priority creditors to accept reduced claim amounts, less the debtor strike a settlement with other junior creditors of the case that cuts out the recalcitrant priority creditor entirely. Additionally, in light of the Circuit split on the issue, the Third Circuit’s ruling raises forum shopping concerns, as debtors (many of whom are organized under the laws of Delaware) will be more likely to commence proceedings in the Delaware bankruptcy court, if only to ensure themselves the benefit of the debtor-friendly rule adopted by the Third Circuit.

Check back with us in the future as we will to continue to cover developments in Jevic.

[2]Compare In re AWECO, Inc 725 F.2d 293 (5th Cir 1984)(finding that a bankruptcy court abuses its discretion in approving a settlement agreement that does not comply with the absolute priority rule); with In re Irdium Operating LlC, 478 F.3d 452 (2d Cir. 2007) (holding that a settlement may deviate from the absolute priority rule in certain circumstances).

The Third Circuit’s decision in In re Trump Entertainment presents interesting opportunities for employers with expired collective bargaining agreements (“CBAs”) seeking to reorganize their companies under Chapter 11 of the Bankruptcy Code. [1] In In re Trump Entertainment, the Court held that a debtor may reject an expired CBA under Section 1113 of the Bankruptcy Code despite the specific limitations on such rejections contained in the National Labor Relations Act (“NLRA”). The Third Circuit’s ruling may provide extra bargaining power and flexibility to companies whose reorganization efforts are impacted by CBAs and labor disputes.

In Trump Entertainment, the debtors were the owners and operators of the Trump Taj Mahal Casino. In 2011, they had entered into a CBA that required the debtors to contribute $3.5 million per year to its pension and an additional $10-12 million per year for healthcare and welfare expenses. A few months prior to expiration of the CBA, the debtor and its union engaged in good faith negotiations to amend and extend the CBA. However, these negotiations ultimately proved unsuccessful and by September 2014, the debtor had $286 million in secured debt and only $12 million in working capital. As a result, the debtor filed for Chapter 11 bankruptcy and as soon as the CBA expired moved to reject the CBA under Section 1113 of the Bankruptcy Code. The Bankruptcy Court granted the debtor’s motion effectively rendering the expired CBA unenforceable and freeing the debtor from the pension and healthcare funding obligations. The union promptly filed a direct appeal to the Third Circuit.

This case presented a matter of first-impression as it involved a conflict between two federal statutes; Section 1113 of the Bankruptcy code, and the NLRA. The NLRA states that an employer cannot unilaterally change the terms of a CBA even after it expires.[2] In contrast, Section 1113 of the Bankruptcy Code allows a debtor to reject its CBA if: (i) the debtor proposed modifications to its CBA that would allow the company to successfully reorganize; (ii) the employees’ authorized representative rejected the employer’s proposals; and (iii) the bankruptcy court determined that the “balance of equities clearly favors” rejecting the CBA.[3] The debtor argued that there should be no distinction between unexpired CBAs and expired CBAs under Section 1113 of the Bankruptcy Code and therefore it was entitled to reject the contract as it had satisfied the other requirements of Section 1113. In contrast, the union argued that an expired CBA could not constitute a “contract” which could be rejected under the terms of Section 1113 of the Bankruptcy Code.

The Court broadly reviewed the legislative purpose behind both statutes before holding that there should be no distinction between expired and unexpired CBAs under Section 1113 of the Bankruptcy Code. In further support for its holding, the Third Circuit noted that this was consistent “with the purpose of the Bankruptcy Code which gives debtors latitude to restructure their affairs.”[4] The Court expanded on this holding by noting that it is preferable for a company to reject its CBA for the sake of preserving jobs than adhering to the stringent terms of its CBA which results in the permanent loss of jobs.[5]

The Third Circuit’s decision may help strengthen reorganizing corporations bargaining position as it expands their ability to shed continuing obligations under an expired CBA. Although this comes at the expense of unions’ potential negotiating positions, a potential debtor’s power is still tempered by the fact that the potential debtor must comply with the strict procedural requirements of Section 1113 of the Bankruptcy Code.

Section 1110 of the Bankruptcy Code provides special protections to lenders and lessors that lease, finance, or conditionally sell aircraft equipment. In 2000, Congress amended section 1110 to add section 1110(c), which provides that a debtor must “immediately surrender and return” aircraft equipment to a secured party if such party is entitled to possession under section 1110(a)(1). Since Congress’ passage of this provision in 2000, debtor airlines and aircraft financiers in airline bankruptcies have disputed how an airline debtor’s “surrender and return” obligations should be interpreted and enforced. Aircraft financiers have argued that “surrender and return” requires the airline debtor to deliver an intact and airworthy aircraft to the location of the financier’s choosing in the condition required under the underlying documents. Airline debtors have argued that “surrender and return” merely requires that the aircraft be made available to the aircraft financier at any location and in any condition.

On April 8, 2016, in the first written decision in In re Republic Airways Holdings, Inc., Judge Sean Lane of the U.S. Bankruptcy Court for the Southern District of New York issued a decision providing guidance on the scope of an airline debtors’ “surrender and return” obligations, holding that “[t]he court will not require the Debtors return the aircraft and related equipment in particular condition for surrender and return.”[1]

The dispute regarding the scope of Republic’s “surrender and return” obligations arose as a result of Republic’s motion seeking to surrender and return aircraft equipment that served as collateral under a loan agreement with Citibank because the aircraft collateral was not required for its long-term business plan. Citibank did not object to Republic’s business judgment or discretion under Sections 365 or 544 of the Bankruptcy Code—the provisions that allow a debtor, respectively, to assume or reject executory contracts or unexpired leases, and to abandon the estate’s burdensome property of inconsequential value and benefit after notice and a hearing.[2] Instead, Citibank argued that the procedures under which Republic actually proposed to perform the “surrender and return” of the aircraft collateral did not satisfy Section 1110(c) of the Code because, among other things, the engines subject to Citibank’s security interest were not installed on the correct airframe and in some cases in different locations than the airframes.[3]

Faced with this objection, and noting that “there’s not a lot of case law out there,”[4] Judge Lane issued a published decision interpreting the “frequently disputed” section 1110(c) of the Code.[5] Relying, in part, on a decision issued in the US Airways bankruptcy in the Eastern District of Virginia and lengthy bench decisions issued in the Northwest Airlines and Delta bankruptcies, Judge Lane rejected most of Citibank’s objections.[6]

The Court refused to require the Debtors to return the aircraft with the matching Citibank engines—which would have been “akin to” forcing the Debtors to comply with the agreement’s conditions for return.[7] The Court noted that bankruptcy courts have rejected similar requirements in several other airline bankruptcy cases: namely US Airways, Northwest Airlines, and Delta Air Lines.[8] Courts have variously found these requirements to be counterintuitive, costly, and burdensome to debtors, their estates, and their creditors.[9]

Judge Lane held that instead of splitting the costs for any engine replacements now, Citibank may instead file a claim for the expenses it incurs for costs associated with the surrender and return of its aircraft and engine collateral.[10] Citibank suggested that—rather than leave the cost determination to a later date in the claims process—the parties split the costs associated with the surrender and return now.[11] Relying on the reasonableness standard that courts use to address surrender and return of aircraft collateral, the Court held that splitting costs at this early stage is inappropriate—first, because the Court lacked sufficient information about the condition of the aircraft and engines at issue, and second, because Citibank failed to take prompt action to address the surrender and return of the aircraft at issue.[12] The Court held, “A claim filed by Citibank—and any resulting decision on that claim—will be a more accurate reflection of the true burdens associated with the surrender and return process than a simple splitting of the costs.”[13]

This decision provides necessary guidance on the scope of an airline debtor’s “surrender and return” obligations, which will help debtors make fleetplan decisions in the early days of the case, as required under section 1110 of the Bankruptcy Code and defer litigation and negotiation regarding the proper allocation of expenses to the claims reconciliation process.

A recent decision by Judge Shelley C. Chapman of the Bankruptcy Court for the Southern District of New York in the Sabine Oil & Gas chapter 11 cases[1] could have significant commercial implications on a U.S. energy sector already stressed by an extended period of low commodity prices. Relying on Bankruptcy Code section 365(a)’s deference to a debtor’s business judgment, the Bankruptcy Court authorized Sabine, a mineral exploration and production company, to reject pre-petition service contracts with its downstream service providers. The Bankruptcy Court also considered and rejected the providers’ arguments that the service contracts could not be rejected under section 365(a) because they were covenants that ran with the land under Texas property law. Because the Bankruptcy Court’s Texas-law analysis was non-binding as a result of the procedural posture of the case, however, future litigation or agreement will be necessary to resolve whether Sabine can, in full, reject “all or some of the terms of the [a]greements.”

In the wake of the Sabine decision, vendors may see energy sector debtors, in particular, invoke the Bankruptcy Court’s analysis to reject servicing contracts. In turn, debtors may expect that motions to reject executory contracts will be hotly contested – particularly under state property law. For all participants, the road ahead for executory contacts in energy sector chapter 11 restructurings may not be a smooth one, and parties should be cognizant of the possible implications of Sabine.

The contracts at issue in Sabine were between Sabine and two of its production service providers (the “Agreements” and the “Service Providers”).[2] In reliance on various exclusivity, volume, and transportation guarantees from Sabine contained in the Agreements, the Service Providers each invested significant capital to develop infrastructure to support Sabine’s mineral extractions and perform agreed services for Sabine. The Service Providers argued that the Agreements could not be rejected because, under governing Texas law, Sabine’s obligations to the Service Providers were not just contracts but rather covenants that, akin to easements, ran with the associated land. Sabine disagreed and characterized the Agreements as mere promises that could be rejected in bankruptcy under the business judgment standard.

Focusing first on the contract rejection standards of section 365(a), the Bankruptcy Court evaluated Sabine’s determination to reject the Agreements under the business judgment test (“whether a reasonable business person would make a similar decision under similar circumstances”). The Bankruptcy Court also considered “whether the debtor’s decision to assume or reject is beneficial to the estate,” and that the “court generally defers to the debtor’s determination … unless the decision to reject is the product of bad faith, whim, or caprice.” The Bankruptcy Court also noted that, unless a provision of the Bankruptcy Code specifically protects a non-debtor, “the interest of the debtor and its estate are paramount; adverse effects on the non-debtor contract party … are irrelevant.” Ultimately, the Bankruptcy Court determined that the Service Providers had not submitted any evidence challenging Sabine’s business judgment and confirmed Sabine’s decision to reject the Agreements.

The Bankruptcy Court then “reluctantly” bifurcated its decision to address separately, and in a “non-binding” manner, the disputed effect of Texas property law on the Agreements.[3] Noting that “the law relating to covenants, while archaic, must still be faithfully applied,” the Bankruptcy Court started with the sixteenth century origins of the concept of a covenant “running with the land” in British common law and carefully traced the law’s development through to its present-day implementation in the segmented mineral extraction, shipment, and refinement process. The Bankruptcy Court determined that the Agreements did not run with the land as either real covenants or equitable servitudes.

Applying Texas case law on covenants, the Bankruptcy Court found that Sabine had “simply engaged [the Service Providers] to perform certain services related to the hydrocarbon products produced by Sabine from its property” and that, accordingly, “[t]he covenants at issue are properly viewed as identifying and delineating the contractual rights and obligations with respect to the services to be provided and not as reserving an interest in the subject real property.” It also concluded that the Agreements did not grant the Service Providers with “a real property interest in [Sabine’s] mineral estate” because the right to transport is not a recognized “stick” in Texas real property law. In Texas, a mineral, once extracted from the land, is no longer real property but converts to personal property, and a party’s right to personal property cannot burden the real property from which it was extracted. Accordingly, rights to a produced mineral do not “touch and concern” the land, and the agreement granting that right cannot be converted into a covenant that runs with the land. That the Service Providers had not collateralized their rights to the extracted minerals with liens on the subject lands further supported the non-binding finding that the Agreements were not covenants that ran with the land. On this basis, the Bankruptcy Court also rejected the Service Providers’ argument that the Agreements were equitable servitudes.

Sabine provides precedent for servicing contracts with downstream vendors to be rejected in bankruptcy pursuant to section 365(a). The limitation on the Bankruptcy Court’s ability to enter a binding decision on certain issues outside the adversary proceeding framework could, however, invite counterparties to contest what are usually ordinary motions to reject executory contracts, with the effect of potentially slowing debtors’ restructurings. In light of Sabine, downstream services vendors will likely reevaluate their current contracts to determine their exposure to the risk of rejection by counterparties. Savvy service providers may revise the drafting of future contracts (or modify existing contracts) to address the deficiencies identified in Sabine and strengthen basic property law protections in the event of future disputes. In addition, maturing debt obligations may lead lenders to require that downstream service providers differentiate their contracts from those at issue in Sabine – i.e., show that they could not be rejected by a debtor-counterparty – to obtain favorable refinancing terms.

For further developments on Sabine’s impact, check back with the HHR Bankruptcy Report.

[2]. As the Court explained, the Service Providers are midstream gathers that sit operationally between upstream companies like Sabine that extract minerals from the ground and downstream refining companies that bring the mineral products to market.

[3]. Pursuant to Orion Pictures v. Showtime Networks, Inc. (In re Orion Pictures), rejection of executory contracts cannot be determined as a contested matter if there are disputed issues to be resolved; instead, an adversary proceeding must be initiated. 4 F.3d 1095 (2d Cir. 1993). However, under In Re The Great Atlantic & Pacific Tea Co., Inc., the court may provide non-binding determinations on disputed legal issues, as it did in Sabine. 544 B.R. 43, at 52 (Bankr. S.D.N.Y. 2016). The Court noted that this bifurcation was “an inefficient use of judicial and private resources” and urged commercial resolution.

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Hughes Hubbard’s Corporate Reorganization & Bankruptcy group represents companies, creditors and trustees in complex restructurings—both in and out of court—and in the multiple types of litigation that insolvency proceedings generate.

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